DeFi protocols limit Ether borrowing – here’s why

After years of preparation, the Ethereum network will transition to a Proof-of-Stake (PoS) consensus mechanism later this month.

The merger represents the most significant blockchain landmark to date and will make power-hungry miners obsolete, replacing them instead with validators who, rather than doing computational work, stake their own funds in order to to secure the network.

The upgrade will see Ethereum under PoS pick up where the proof-of-work (PoW) chain left off, with all assets preserved. However, the original PoW chain will not cease to exist and all assets will be preserved there as well.

While the value of assets on the PoW chain is expected to drop rapidly to zero, some traders predict that the remaining ETH on the legacy chain (ETHW) will have some valueeven if it is only a fraction of that of “real” ETH.

As speculators seek to maximize their pre-merger exposure to ETH via borrowing, DeFi lending protocols such as Aave and Compound are anticipating problems and taking steps to mitigate them.

As ETH borrowing usage approaches capacity, depositors may find themselves unable to withdraw their funds. More importantly for the health of the protocols, the lack of ETH could also interfere with on-chain liquidation positions backed by ETH. Third, the potential ripple effects on the stETH/ETH peg could lead to further cascading liquidations.

Aave’s solution, for temporarily suspend ETH borrowing until post-merger, has already passed the project’s decentralized governance process, and currently the ETH lending market is around 80% utilization.

Read more: Compound Finance upgrade bug freezes $830 million in crypto

The compound, on the other hand, is to propose a borrowing cap of 100K ETH (currently ~500K ETH available), as well as a sharp increase in interest rates for borrowers above 80% utilization, approaching 1000% APR at full use. Such high borrowing rates should make the ETHW speculative strategy described above unprofitable, even when borrowing in the short term. Voting on the proposal is still ongoing, with 100% support at the time of writing.

However, none of these strategies account for large-scale withdrawals, which would have the same effect on usage. Current ETH lenders may also choose to exit in an attempt to make a profit on ETHW.

The two projects expect to readjust their ETH markets post-merger, via new governance proposals.

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